Mortgages have their worst month in over 10 years

Mortgages took a good old fashioned, bat-to-the-kneecap beating last week, making this the worst month for the sector in over ten years, bank researchers said. While investors were selling to ward off duration - or, at the very least, stayed on the sidelines - supply was robust.

The numbers pretty much say it all. Over the Wednesday-to-Wednesday period, spreads on 30-year Fannie Mae 5s through 6s widened 25 to 29 basis points. Meanwhile, 15s did slightly better with 4.5s and 5.5s 13 basis points weaker, and 5s out 19 basis points. Lehman Brothers reports that through July 30, the MBS Index has under-performed Treasuries by 101 basis points for the month. This is the worst showing in more than a decade, according to Lehman.

Investors are reluctant to enter the market at this time. However, once the market stabilizes and a new yield curve range is established, buysiders are expected to take advantage of the attractive yield levels. Banks are sitting on a significant amount of cash, says Lehman. Additionally, paydowns in July are expected to set a new record high.

At the same time, analysts are becoming more favorable on the MBS sector. JPMorgan Securities, for example, is positive on the basis, but through curve/convexity neutral trades. In particular, the firm recommended Gold 5s over FNMA 5s in August. Gold 5s are getting support from the CMO bid. JPMorgan also prefers GNMA II 5.5s over GNMA I 5s. In the firms most recent report, JPMorgan noted that the implementation of the new GNMA II guidelines has led to low WAC GNMA II pools. For example, July GNMA II 5.5s have a 5.94% WAC.

Lehman says it is sticking with its mortgage overweight call, though they are unwilling to add to their mortgage allocation. Their reason for continued support for the sector is that the firm believes the economy will recover slowly, which bodes well for the carry trade and ongoing bank demand. As far as their recommendations go, Lehman advises buying 30-year 5s versus 2s/10s swaps. This trade will benefit as bank demand picks up and vols decline as the Federal Open Market Committee holds steady. The firm also suggests investors sell GNMA 6% TBAs and buy Gold 6s TBAs. Analysts further recommend selling GNMA 6.5 TBAs to buy Gold 6.5 TBAs. They expect a convergence in premium prepayments, which will hurt Ginnies. They also like Gold paper due to its premium discount to Fannies, higher dollar rolls and slower prepayments versus Fannies.

Credit Suisse First Boston is maintaining its overweight recommendation on mortgages over swaps and agencies, but the firm is neutral versus Treasuries. In general, CSFB recommends an overweight on 15s versus 30s, particularly 15-year 4.5s versus 30-year 5s. Analysts also favor FNMA 5.5s over synthetic combinations; conventionals over GNMAs; and Golds over Fannies.

Meanwhile, UBS Warburg moved to a full overweight saying that mortgages look very cheap to swaps, Treasurys and corporates. The firm recommends that corporate crossover buyers look at five-year PACs and shorter sectors.

Although the spread widening has made the sector more attractive, Lehman warns that mortgage extension risk remains a serious threat in a further market sell-off. The firm notes that the MBS Index is close to its point of worst convexity with durations moving by $350 billion for every 50 basis point move (up or down) in rates. Lehman also notes that mortgage servicers have not been particularly active in the recent sell-off, but will become active sellers in a rising rate environment.

As expected, mortgage applications declined for the week ending July 25 as mortgage rates surged. According to the Mortgage Bankers Association (MBA), the Purchase Index fell 3.5% to 427 as purchase applications remained strong; however, the Refi Index plunged 33% to 4146. This is in-line with what analysts were expecting. The MBA also reported that, as a percentage of total mortgage activity, refinancings declined to 60.4% from 68.7%. At the same time, ARM share increased to 20.6% from 16.7%. Looking ahead, Lehman says it expects the Refi Index to decline towards 3000 over the coming weeks.

Given the latest sell-off, Citigroup says that only 30% of the mortgage market is still refinanceable. Meanwhile, 5.5s are totally out of the window, while many 6s are as well. At this time, prepayment speeds are forecast to peak in July, than decline modestly in August before recording a dramatic slowing in September. The drop in refinancings is expected to hit prepayment speeds beginning in September. Currently, consensus anticipates FNMA 2002 5.5s to peak at 54% CPR in July and fall to 38% CPR by September. The 2002 6s are expected to hit 69% CPR in July and fall to 57% by fall. July prepayment reports will be released on Thursday, August 7.

In the second quarter of this year, the number of cash-outs plunged. According to the most recent quarterly refinance review released by Freddie Mac, 32% of Freddie-owned loans that were refinanced resulted in new mortgages that were at least 5% more in amount compared to the original mortgages. This is compared to the second quarter of last year, when 63% of refinanced loans had higher new loan amounts, and to the first quarter of 2003 when 41% of refinanced loans had higher new loan amounts.

Freddie Deputy Chief Economist Amy Crews Cutts said it's hardly surprising that 32% is the smallest number of cash-out refinancings that has been recorded since Freddie had began releasing this report in 1985. Mortgage rates are now at such incredibly low levels that homeowners are currently refinancing primarily for the low rates, and not to take out equity. She added that as mortgage rates start to rise, there would likely be an increase in the number of cashout loans. This is due to the disappearance of the refinance incentive offered by the lowered interest rates. Further, homeowners who would be refinancing with higher rates are doing so to get equity in their homes.

Crews Cutts added that so far, in 2003, homeowners have converted about $50 billion of their home equity into cash. This is compared with $96 billion in the year 2002. But she also noted that the amount of cash homeowners have taken out in equity is merely a small percentage of the $67.7 trillion worth of equity value currently held in single-family homes. Homeowners who are now refinancing their original fixed-rate mortgages are moving into new mortgages that are, on average, 1 1/8 % lower than the original one. Thus refinancing at this stage could not only produce additional cash, but would also leave the borrower with less monthly payments. In aggregate, these interest savings add up to above $600 million per month for those who refinanced this year.

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